Is Volatility Risk?

I disagree with the majority of people I respect in the investment industry about volatility. This is an uncomfortable situation, as holding a view contrary to people more intelligent than yourself is rarely a sensible course of action.  Nevertheless, I shall persevere.

Most of the aforementioned investors have claimed at some point that “volatility is not risk”.  This is, of course, correct; risk is a multi-faceted concept, which no single metric can successfully capture, however, the implicit (sometimes explicit) extension of this argument is that volatility is not a valid measure of risk at all.  I do not believe this to be true.

The renunciation of volatility is often followed by the comment that “permanent capital impairment” is the only genuine risk. This view assumes that risk is based on the probability of the fundamental value of an investment being than less you paid for it.  The problem with this pure perspective is that it assumes that permanent capital impairment is solely about the asset and not the investor, and that the variability of an asset’s price through time is irrelevant.

From a behavioural perspective, volatility and permanent capital impairment are inextricably linked. I would assume that the most common cause of the latter is not a fundamental change in an asset’s intrinsic value but a decision by the investor to sell at an inopportune time.  The path of returns for any given asset is crucial; volatility is not simply about the variability of an asset’s price, but how those fluctuations impact investor behaviour and the resultant cost.

As volatility is a somewhat nebulous concept, it is worth considering what drives fluctuations in asset prices.  I tend to think of three related aspects:

1) A change in the fundamental value of an asset.

2) Uncertainty over the fundamental value of an asset and our behavioural reaction to uncertainty.

3) Investors reacting to the behaviour of other investors (momentum) or anticipating how they think other investors will behave. Markets are reflexive.

Investors do not experience volatility in isolation, it is not simply about detached price movements – there are inevitably accompanying narratives that lure us into action.  Volatility is circular; it is created by our behaviour – our emotion laden decision making, our myopia, our loss aversion, our recency bias – and in turn it drives our behaviour. It is often absurd and frustrating, frequently bearing no relation to sound fundamental investment thinking, however, it is a reality and it matters.

In addition to the behavioural nature of volatility, it is also heavily reliant on technical factors such as how an asset is priced and how it is traded. To take an example of this, let’s assume that an S&P 500 index tracker only provided liquidity windows every five years and the underlying components were revalued quarterly based on some form of DCF methodology.  Given that the holdings are identical would the risk differ from the market priced, daily liquid version we have available today? It is almost certain that the volatility would be considerably lower*.

Someone from the ‘permanent capital impairment’ camp would likely argue that this proves the flaw in using volatility as risk – the same assets can exhibit different levels of risk if judged by their volatility just by altering how they are traded and valued. However, the notion that volatility should be ignored because it is about more than simply the fundamental features of an asset seems spurious – a sensible theoretical concept that does not match reality. Investors have to experience price variability when holding investments and that has material implications for their behaviour and decision making.

Volatility is an imperfect measure of risk, particularly in regard to the distribution of asset class returns (non-normality) and assumptions around correlation. It is also backward looking and insensitive to valuation. It is certainly limited in the following circumstances:

– Investments with significant tail risk (such as selling insurance). Volatility is a poor gauge to the potential risk in such situations.

– Undiversified portfolios with high idiosyncratic risk.

– Assets with stale / slow pricing such as direct property and private equity.  Assets which are illiquid or aren’t daily traded often benefit from compelling Sharpe Ratios, simply because volatility is subdued relative to more frequently priced counterparts. This is never a fair comparison.  There is certainly a behavioural return premium attached to illiquid assets because it is harder to make stupid decisions when you are unable to trade.

We should be measured when conflating investment risk with any specific metric, it is heavily dependent on the individual, the environment, the instrument and the asset(s). Each method we employ will have limitations, take the following two examples:

1) Assume that the long-term volatility of global equities is 17% and you make an investment when realised volatility has been 17% over the previous three years.  In the subsequent three year period, global equities rise by 50% (primarily through valuation change) with a realised volatility of 14%.  Given that the historic volatility (three year) is  lower than when you made your investment, is the risk, other things being equal, now reduced? Given valuations are significantly higher it would be difficult to make this case, although using a simple (short-term) standalone volatility look-back would suggest so.

2) The probability of realising a loss over a 30 year holding period for global equities is low; from a permanent capital impairment perspective, does that mean that for those with a 30 year holding period holding equity exposure is close to riskless? ** To believe so suggests that the path, distribution and sequence of returns are irrelevant, as is how an investor may react to these factors.

Investment risk is nebulous and difficult to define – there is no unimpeachable means of gauging it. Volatility certainly has limitations and it is not ‘risk’, but can be an important measure of it.  One should never view risk purely through the lens of volatility, but ignoring it is equally naive – permanent capital impairment is as much a behavioural phenomenon driven by the individual human reaction to price fluctuations as it is about the fundamental value of any asset.

*We now have greater liquidity risk.

** Of course a 30 year time horizon is only such for one year, then it becomes a 29 year horizon.

Please note all views expressed in this article are my own and are not necessarily shared by my employer.